The ‘sweet spot’ of credit
Even before the COVID-19 pandemic rocked global financial markets, Australia was on its way to join the lower yield world. Now, Australian investors in search of stable, current income strategies are facing a challenge as strategies of the past are unlikely to generate the returns and levels of income they once provided.
This can be observed across the risk spectrum with the Reserve Bank of Australia’s (the “RBA”) cash rate at 0.10% and a large part of Australian government bond yields below 1%, all the way up the risk spectrum to Australian banks’ equity and their now more uncertain dividends.
We believe solutions to generate higher income and diversification for Australian investors’ portfolios exist within certain parts of the global fixed income markets that provide current income and attractive relative yields with downside protection1 and limited exposure to interest rate duration; we call it the ‘sweet spot’ of credit.
To be successful in what we call the ‘sweet spot’, we believe an arduous focus on capital preservation through fundamental credit selection and the flexibility to capitalise on the most attractive relative value are key. We believe this can be achieved via our ability to identify attractive relative value opportunities in the more senior, higher quality segments of the loan, bond and structured credit markets and shift allocations among these asset classes as appropriate. In addition to maintaining a well-diversified portfolio of senior debt, a 50% allocation to investment grade credit further strengthens the high-quality nature of the strategy.
The low yield world
Until recently, Australian investors didn’t have to look too far for attractive yields and income, but the last 24 months have accelerated Australia’s participation in the low cash rate and bond yield world.
According to a report published by the ASX in 20182, in the last 20 years through December 2017, Australian cash annualised gross return was 4.6% p.a. Interestingly, cash returned 3.6% p.a. in the last 10 years through December 2017, which suggests a downward trajectory of the RBA target cash rate and term deposit rates (Chart 1).
With the target RBA cash rate currently sitting at 0.10%, achieving the returns of the past in cash products seems unlikely for Australian investors.
The risk-return spectrum
Moving up the risk spectrum (with risk defined as asset price volatility) in the last 10 years, Australian government and corporate bonds have offered attractive yields, generating higher income and returns than cash, with the same ASX report showing returns of c. 6% p.a. for the 10 years to December 2017.
These attractive returns and levels of income have partly been due to a falling yield environment which generates capital gains in fixed rate bonds. When realised, these gains are distributed as income alongside interest payments.
As illustrated in Chart 2 below, over the last 10 years through March 2020, Australian 10-year government bond yields went from over 5% to around 1% at the start of 2021, and in the last 12 months, from over 1.5% in March 2019 to an all-time low of 0.57% in March 2020. This latest drop has driven strong returns and provided the expected counterbalance to riskier assets such as equity in periods of volatility.
However, looking ahead, with 84% of Australia government bonds currently trading at or above 100% of face value and little room for yields to move further down (although they could go negative!), we believe income generation and outsized returns are unlikely while the risk of rising yields and capital losses cannot be ignored.
Finally, moving all the way up the risk spectrum to equities, Australian investors have enjoyed many years of high and dependable dividend payments from the major Australian banks. For those happy to endure some price volatility going up the risk spectrum, the four major Australian banks have been a reliable source of higher income.
A conservative approach
However, in the wake of the COVID-19 crisis and the ensuing economic turmoil, an unprecedented level of uncertainty leaves many questioning the likelihood and reliability of those dividends as the banks employ a more conservative approach to cash management. As an example, in 2020 NAB decided to cut their dividend payment by 64%. NAB has not seen such low dividends since 1994. A common observation can be made across the four major Australian banks – even during the Global Financial Crisis (the GFC), dividends did not decrease as precipitously as they have recently (Chart 3). This has highlighted to investors that unlike fixed income and credit instruments, shares have no contractual obligation to a fixed level of distribution.
The ‘sweet spot’ of credit
The challenge posed by low yields is not new for many global investors. Since its founding in 1997, the Ares Credit Group has been able to diversify portfolios with asset classes that we believe offer attractive yields and current income within global fixed income markets. We call it the ‘sweet spot’ of credit.
We believe high quality corporate and structured credit presents the most compelling risk-reward opportunity. Our strategy seeks to avoid riskier asset classes (equities) as well as minimise exposure to the more stressed, low quality segments of the credit market (CCC-rated bonds and loans). We believe this approach reduces volatility and default risk and further takes advantage of the downside protection offered by senior and often secured credit position in the capital structure of corporate bonds and loans and asset backed securities. In tandem, Ares believes this particular focus offers greater opportunities for current income in yield than traditional fixed income and passive strategies.
Within global fixed income specifically, sovereign yields remain low in the wake of the pandemic, resulting in past performance favouring higher interest rate duration assets (Chart 5). For example, U.S. government bonds and high-grade corporate bonds that have higher interest rate duration risk than bank loans or investment grade CLO (collateralised loan obligation) debt have outperformed (higher return and lower volatility). But, with government bond yields at or close to historical lows, the potential return and current income generation from the lower end of the risk spectrum seems challenged.
Our focus is therefore on the asset classes that currently offer higher relative yields. These higher yields are largely derived from the credit spreads these securities pay on top of government bond yields. These spreads compensate investors for the additional risk that they take by investing in credit. Even as markets recover from the March 2020 dislocation, we believe further spread compression amid a volatile and uncertain economic backdrop presents ample opportunity for managers looking to take advantage of inefficiently priced segments of the fixed income markets.
And, while dynamic allocation across asset classes is certainly a distinctive feature of Ares’ strategy, we recognise that falling yields is a global trend across developed and emerging markets and seek to opportunistically allocate across regions.
In other words, current income and potential returns are attractive in the sweet spot of credit, but to fully optimise the strategy, we believe managers must be focused on minimising default risk and capturing relative value opportunities.
As a credit investor, protecting the downside3, i.e, avoiding defaults and capital losses, is part of the Ares DNA.
Default risk analysis is fully incorporated into Ares’ investment process, which employs rigorous monitoring of credit performance with the robust use of data analytics to identify potential downgrade candidates. This focus has resulted in Ares experiencing significantly lower defaults in its broadly syndicated bank loan and high yield bond strategies since inception, including during times of stress. At the height of the GFC fall-out in 2009, U.S. high yield bond and loan markets saw default rates rise close to 11% and 15%,4 respectively, while Ares’ flagship bank loan fund and U.S. High Yield composite5 have experienced fewer than 4%. Ares’ European portfolios performed similarly, with its flagship European high yield portfolios experiencing a 3.4% default rate during the GFC versus the market’s 13%. During the same period, Ares’ flagship European loans portfolios experienced 0 defaults.6
Independent of the fund’s 50% allocation to investment grade credit, Ares is intently focused on maintaining a high-quality portfolio. Given the strength of today’s market, we have positioned the portfolio to be moderately “risk-on” and believe there is considerable value to be uncovered in the Single-B portion of the market. However, disciplined credit selection remains key to constructing a balanced portfolio that is both downside protected7 and poised to capture the upside. In current market conditions, we believe our ability to significantly under-default the market will again prove critical to capitalising on opportunities available in the sweet spot of credit.
Finally, a heightened focus on portfolio positioning, volatility and duration are of particular importance during times of stress and economic uncertainty to manage downside risk. As an example, the Fund’s exposure to interest rate risk measured by effective duration is currently around 1.6 years with 70% of the Fund invested in floating rate instruments. Interestingly, a large portion of these floating rate instruments have embedded income protection against lower or negative rates through LIBOR floors. This means that out of the 1.6 years of interest rate duration, 50% of the Fund’s duration risk is an asymmetric exposure that will benefit the Fund if rates fall and not impact returns if interest rates rise.
Relative value analysis
Our investment process places a strong emphasis on relative value analyses to identify optimal risk-adjusted investment opportunities, and we believe relative value will be of critical importance as credit spreads continue to tighten across our target asset classes. Furthermore, today’s favourable technical backdrop, discussed in greater detail below, presents a compelling argument for casting a wide net in the fixed income universe.
In loans, CLOs are the dominant buyer and holder of loans, and Street forecasts predict an increase in gross CLO issuance in 2021 which should help to offset a pick-up in leveraged loan issuance brought about by any uptick in LBO-related deals. A tightening of CLO AAA spreads to 90-110 bps could accelerate the pace of CLO issuance and cause loan spreads to compress further. At the same time, retail investors, which at one point represented 20% of the US loan market, have fallen to a mere 5%8 and could be an incremental driver of demand should rising rate concerns return in a strengthening economic environment. The European leveraged loan market continues to be wholly owned by institutional investors, which should promote a stable pathway of moderate spread tightening over the next 12 months.
Supply and demand
Within the bond market, we expect the pace of U.S. new issuance to cool from 2020’s torrid tempo but remain elevated from a historical perspective as companies seek to lock in low yields. European high yield bond supply is likely to increase in 2021, which can be attributed to the large cohort of BB-rated issuers with ongoing financing needs, many of which entered the asset class this year as fallen angels. We believe supply in both markets will be met by strong demand from both institutional and retail investors seeking relatively attractive valuations, in an environment where traditional investment-grade fixed income portfolios trade with historically low yields and meaningful interest rate duration.
Alternative credit continues to provide multiple ways to find value and protection in different market conditions. CLO Debt in particular has consistently provided a premium to corporate yields across rating classes, ranging from 2.6% for single-A tranches to 7.0% for double-B rated tranches.9 We believe the asset class is currently providing attractive yields but we remain patient and continue to favour transactions with high quality underlying portfolios and ample time remaining in their reinvestment periods. Given our cautious stance despite the current market strength, we continue to be conservative in our underwriting of potential investments and will not stretch on credits.
Regardless of the market environment, the Ares approach to investing with full transparency to the underlying assets allows for the ability to sift through a variety of available investment opportunities to find the assets that best provide the combination of current income with loss protection, which we can combine with loans and bonds to build a portfolio that meets our investors’ needs.
We believe the ‘sweet spot of credit’, comprising corporate and structured markets, offers a compelling opportunity for Australian investors seeking diversification and stable current income in varied market environments. We believe a nimble and flexible style of portfolio management with the ability to dynamically allocate across asset classes when shifts in relative value occur is paramount. Further, we believe the ability to identify and unlock value, especially in currently volatile and bifurcated markets, is a key strength of Ares.
1 References to “downside protection” or similar language are not guaranteed against loss of investment capital or value.
2 “2018 Russell Investments/ASX Long Term Investing Report” June 2018, https://www.asx.com.au/documents/research/russell-asx-long-term-investing-report-2018.pdf
3 References to “downside protection” or similar language are not guaranteed against loss of investment capital or value.
4 J.P. Morgan Default Monitor, as of June 1, 2020.
5 Performance for High Yield Bonds is represented by the U.S. High Yield Composite, which includes all actual, fully discretionary, fee-paying, separately managed portfolios that primarily invest in U.S. high yield fixed income securities.
6 Past performance is not indicative of future results.
7 References to “downside protection” or similar language are not guaranteed against loss of investment capital or value.
8 JP Morgan, as of December 15, 2020.
9 Source: J.P. Morgan CLOIE, as of December 31, 2020.
*Ares Australia Management is a strategic joint venture between Ares Management (Ares) and Fidante formed in 2019 in order to coordinate the marketing and investment management of investor capital from Australia and New Zealand for Ares’ various credit, private equity and real estate strategies.